Fed Vice Chairman Speaks On Evolution of Supervisory Stress Tests

[1]Speaking at the Riksbank Macroprudential Conference in Stockholm, Sweden, on Wednesday, U.S. Federal Reserve[2] Vice Chairman Stanley Fischer related to the audience[3] the critical role that stress tests played in restoring the U.S. financial system to health and of the continued evolution of those tests over the last six years.

Fischer said that stress testing has become a "cornerstone" of a new approach to regulating and supervising the largest financial institutions in the United States, beginning with the first such test, the Supervisory Capital Asset Program (SCAP), conducted in 2009 at the depth of the financial crisis.

"The results clearly demonstrated the value of simultaneous, forward-looking supervisory assessments of capital adequacy under stressed conditions," Fischer said. "The SCAP was also a key contributor to the relatively rapid restoration of the financial health of the U.S. banking system."

Even though the Fed's approach to stress testing has evolved in the last six years, some elements of the original SCAP remain in the stress tests conducted by the Fed today, such as supervisory stress scenarios applicable to all firms; defined consequences for firms that are deemed to be insufficiently capitalized; and public disclosure of the stress test results, according to Fischer.

The Fed has initiated several stress test innovations building on the success of that first SCAP, according to Fischer, in addition to making some "important improvements" in the stress test process.

The innovations are:

First, developing supervisory models and processes that allow the Fed to independently evaluate and determine whether those financial institutions tested are able to continue lending to consumers under adverse economic and financial conditions;

Second, using the supervisory stress test as a key input into the largest banks' annual supervisory evaluation of capital adequacy;

Third, supervisory stress testing has resulted in greater supervisory transparency around the Fed's processes, methodologies, and results of stress testing.

Fischer said the Fed is continually evaluating its stress test programs and making appropriate changes.

"Examples of such changes to date include the assumption of default by each firm's largest counterparty and the assumption that firms would not curtail lending to consumers and businesses, even under severely adverse conditions," Fischer said. "As part of that assessment process, we are also currently seeking feedback from the industry, market analysts, and academics about the program."

Supervisory stress testing is not a "static" exercise, Fischer said, and it must adapt to economic and financial environment changes as well as innovations in modeling technology. A key aspect of this ongoing adaptation is ensuring appropriate tests for non-bank systemically important financial institutions (SIFIs), since the sources of risk faced by non-banks are distinctly different from those faced by banks, Fischer said.

Fischer addressed the assertion by some that supervisory stress tests create a "model monoculture," as termed by former Fed Chairman Ben Bernanke, where common scenarios and models used in supervisory stress tests are similar and miss the same key risks. The Fed has attempted to address the issue with "appropriate disclosure" about the stress test, but has not published full details that banks could use to manage the test that would make it easy to "game the test" – which is a potential negative consequence of too much transparency, Fischer said.